Remarks of Board Member Bill Gradison

It is a pleasure to be with you today, especially because I was invited by two old friends from whom I've learned so much over the years. I grappled with tax issues for sixteen years as a member of the Committee on Ways and Means --better known by those of us who served on it as the Committee on Woes and Moans. Fortunately for me, and for the nation, folks like Doug Bates and Bob Shapiro were there to advise us.

When I left the House in 1993, I asked myself what legislative initiatives I felt the best about -- those which might in my mind justify eighteen years in the House. One involved taxes, specifically, indexing the individual income tax, which was achieved with the help of Senators Bill Armstrong and Bob Dole. The other initiative was adding hospice benefits to Medicare, which was accomplished with the help of then Congressman Leon Panetta.

Having achieved my goal of making the tax system simpler and fairer, I turned my attention to health care. And after assuring every American quality health care at an affordable price, I have turned my attention to protecting investors by auditing auditors as a founding member of the Public Company Accounting Oversight Board.

Those of you who track the oversight of auditors and, I hope, those of you who are investors in our public markets will know that PCAOB has been in place for a just over three years. PCAOB was established by Title I of the Sarbanes-Oxley Act to oversee the auditors of public companies in the wake of the financial failures at WorldCom and Enron and the related collapse of Arthur Andersen.

We are, as Congress decreed in the Act, a private-sector, non-profit entity. Typically, the Board comprises five members – appointed by the Securities and Exchange Commission – but we are currently a body of four, as a result of the departure of Bill McDonough, who served with great distinction as PCAOB’s first Chair. I was honored to be named acting chairman by the SEC in early December.

Before we go any further, I must say that the views I express today are my own and not those of the other Board members or the staff of the PCAOB.

After three years of helping develop our congressionally mandated oversight of accounting firms, I believe that 2006 will be the most important year so far for the PCAOB. Let me explain why I feel this way.

All of the principal milestones I see this year relate to our statutory mandate to inspect the accounting firms that are registered with PCAOB. As you probably know, any accounting firm that wishes to audit the financial statements of a company that trades in U.S. securities markets must be registered with the PCAOB.

And any registered firm that audits at least one public company client must be inspected by the Board at least once every three years. Those with more than 100 public company audit clients must be inspected annually.

In 2006, we will be approaching the end of the first three-year inspection cycle for some domestic firms that audit fewer than 100 public companies, or “issuers” as defined in the Act.

Also, for the first time, the Board will be assessing the degree to which accounting firms have addressed quality control deficiencies identified during prior-year inspections. To the extent that firms’ efforts to address the deficiencies do not satisfy the Board, we are required by the Act to make the uncorrected deficiencies public.

Also, for the first time, in the next few months I expect the Board will open the window to our inspection findings with regard to all of the 2004 domestic firm inspections. While PCAOB is prohibited from identifying specific firms or issuers, the Board can publish reports that provide an overview of the results of its inspections of quality control at registered public accounting firms.

These reports will provide a baseline against which future inspection findings can be compared, providing an opportunity not only to observe where quality control weaknesses have been identified, but also, in years to come, to judge whether progress is being made in achieving the Board's statutory mission to oversee the auditors of public companies in order to “protect the interest of investors and further the public interest in informative, fair and independent audit reports”.

The Board issued its first such report on November 30 of last year, when we reported on the initial implementation of our standard for audits of companies’ internal control over financial reporting.

I expect these reports will be very useful to auditors, issuers, and investors alike, and, eventually, to tax specialists, such as yourselves. Indeed taxes have been an important part of PCAOB's work, both in our standards-setting and inspections. This should not be surprising because taxes are almost always "material" in the auditing the financials of public companies.

Last year, the Board adopted rules relating to auditors’ ethics and independence as they relate to tax services. The rules are pending before the SEC, and identify three circumstances in which the provision of tax services impairs an auditor's independence:

• One rule treats registered public accounting firms as not independent of their audit clients if they enter into contingent fee arrangements with those clients.
• Another rule treats a registered public accounting firm as not independent if the firm provides services related to marketing, planning, or opining in favor of a tax treatment on a transaction that is based on an aggressive interpretation of applicable tax laws and regulations. Transactions that are “listed” by Treasury would fall into this category of prohibitions.
• Yet another rule would treat a registered public accounting firm as not independent if the firm provides tax services to certain members of management who serve in financial reporting oversight roles at an audit client or to the immediate family members of such persons.

The rules further implement the Act's requirements by strengthening the auditor's responsibilities in connection with seeking audit committee pre-approval of tax services. Specifically, they would require a registered public accounting firm that seeks such pre-approval to describe proposed tax services engagements, in writing, for the audit committee; to discuss with the audit committee the potential effects of the services on the firm's independence; and to document the substance of that discussion.

As I said when the Board proposed these rules relating to auditors’ independence and ethics, obtaining both audit and tax services from the same firm often proves helpful to issuers in light of the auditor’s detailed knowledge of the issuer’s business. As a result, whether an issuer’s auditor is engaged to provide tax advice is properly left to the discretion of the audit committee, and I believe the rules, as adopted, provide a useful and targeted approach to auditor independence that is in the public interest.

The rules adopted by the Board are an important part, but only a part, of audit standards bearing on the relationship between audit quality and tax services. In addition to the approved rules, and other current Board standards, there may be others on the horizon which could enhance the quality of the auditing of tax provisions. I have in mind a standard on communications with audit committees, which the Board may consider this year.

The Board’s standard on audits of internal control over financial reporting, Auditing Standard No. 2, also should be mentioned in this regard. Internal controls over the reporting of tax reserves require the same level of scrutiny by management as other internal controls. This matter was highlighted in May of last year by Jefferson Wells International and the Institute of Internal Auditors in their Sarbanes-Oxley Implementation Survey.

In the portion of that report on gaps in internal controls they stated: “There is also evidence that controls within the tax area tend to receive less attention than they warrant. Federal taxes, state sales and property taxes, for example, usually originate from a diverse range of feeder systems. Each of these information sources, as well as the subjective judgments used to determine tax exposure, require effective controls and processes.”

As I see it, PCAOB’s main role in assuring that the provision of tax services enhances, or at least does not weaken, audit quality may come through the inspection process. Future inspection reports may help inform the Board of the impact on audit quality of the Board’s rules relating to tax services and assist the Board in determining whether additional steps need to be taken with regard to the role that auditors play in providing tax services to their audit clients.

Our inspectors may focus on a variety of tax issues related to a firm's audit practice. For example, our inspectors may look to see whether the audit team was appropriately involved in the audit of the income tax accounts and whether errors in those accounts were properly recorded and communicated, as required, to the audit committee.

Our inspectors are also keenly aware, as firms should be, of the independence boundaries around tax work. To comply with independence requirements, the auditor needs to leave it to the issuer to perform certain computations and analysis related to the tax provision and deferred tax assets and liabilities. The auditor may not perform those computations and analyses for the issuer, and our inspectors will look to see whether an auditor crosses that boundary.

And, of course, in the tax area and other areas, our inspectors look at the adequacy of audit documentation. Appropriate documentation of audit procedures performed in income tax accounts, including both contingency reserves and the core income tax accounts themselves, is plainly important. Without adequate documentation, it may be difficult or impossible to determine reliably whether general income tax reserves, deferred tax liabilities, or income projections supporting the valuation of deferred tax assets were sufficiently audited, tested, or evaluated.

I hope that the results of our inspections will result in public reports that will be helpful to auditors, issuers, tax practitioners, and – most importantly – investors.

The Act gave the Board broad authority not only to register and inspect public accounting firms, but to set standards for auditing and professional practice, as well as to investigate and discipline registered firms for violations of the Act, the rules of the Board, and securities rules as they relate to the audit of public companies.

By setting standards for audits and professional practice, the Board can play a strong role in directing how auditors perform their duties on behalf of investors. I already mentioned that the Board may consider a standard on auditors’ communications with their clients’ audit committees, but we have several other potential standards in the works.

Among the areas that the Board is exploring for possible standards-setting are elements of quality control at registered accounting firms and engagement quality reviews, also known as concurring or second-partner reviews.

As the Board considers what auditing standards to take up, we rely heavily on our Standing Advisory Group, a truly distinguished group of 31 individuals with expertise in investing, accounting, auditing, corporate finance, and corporate governance. Just yesterday, we met with the group to hear their views on auditors’ use of specialists in performing audits, as well as risk assessment and the auditor's consideration of materiality in planning an audit.

We also heard a very lively discussion of litigation-related clauses in audit engagement letters and what those clauses might mean for an auditor’s independence from his or her client.

The Standing Advisory Group provides valuable guidance to the Board as we consider auditing standards, but it is by no means the only source of input. The Board and the staff meet formally and informally with investors, auditors, academics, and leaders of small and large companies to obtain feedback about our work. And we always seek public comment on the standards and rules that are proposed by the Board.

Our standards and rules are enforced through our inspection program, not just through threat of public exposure in inspection reports, but through encouragement that the firms and their individual auditors correct missteps and errors very quickly, driving improvements in firms' public company audit practices on an ongoing basis.

Of course, when recalcitrance, ignorance, incompetence, or outright malfeasance by auditors threatens the public trust in financial statements, the Act gives the Board ample authority to curtail or deny the ability of those auditors to opine on the financial statements of public companies.

One of the areas that will receive close attention from our inspectors this year is the firms’ performance of audits of internal control over financial reporting. As part of PCAOB’s efforts to improve the efficiency and effectiveness of these audits, our inspectors, as they go into the field this spring, will be making a focused effort to ascertain that auditors have implemented the guidance issued by the Board last May 16.

That guidance encouraged accounting firms to integrate their audits of internal control with their audits of the client's financial statements, so that evidence gathered and tests conducted in the context of either audit contribute to completion of both audits; to exercise judgment to tailor their audit plans to the risks facing individual audit clients; and to use a top-down approach that begins with company-level controls over financial reporting.

In 2005, we established and dispatched a team of highly trained inspectors to conduct inspections of audits of internal control over financial reporting, ICFR, by the eight largest U.S. firms.

To communicate to firms the findings of the ICFR inspection team and provide ongoing guidance and direction for the subsequent year’s ICFR audit, the inspection division leadership met with the leaderships of the firms beginning in the fall of 2005.

The objective of these meetings was to provide feedback to the firms on their implementation of AS 2 and to discuss effectiveness and efficiency issues based on observations obtained during the inspections. The meetings were also intended as a mechanism to obtain information on improvements the firms had made or anticipated making to improve the effectiveness and efficiency of their integrated audits going forward.

Our approach to inspections in 2006 will change somewhat from what it was in 2005. This year, we will integrate our inspections of ICFR audits into our existing inspection process to mirror our expectations that the firms will integrate ICFR audits into their existing audit process.

The overall approach for 2006 will be for our inspectors to conduct inspections of the firms’ integrated audits with emphasis on how the firms have implemented our Staff Q&As and the November 2005 Board Report. An integrated audit is one where the audit of internal control over financial reporting and the audit of the financial statements are performed in tandem to arrive at opinions for both audits. Because there should be a close correlation between the audits, the impact of issues identified in one audit must be assessed to determine not only its impact on that audit, but its impact on the other audit as well.

Our intent is that inspections conducted in 2006 will focus on whether the firms have gained “efficiencies” principally by implementing the guidance in the Staff Q&As and the Board Report. Through periodic meetings with the firms, our inspectors will identify areas where firms need to be more efficient in the audit procedures they perform. The inspections of ICFR audits are a big part of why I expect 2006 to be such an important year in the life of the PCAOB.

2006 will be my fourth year with this remarkable organization. I appreciated the opportunity that was given to me when the SEC appointed me as one of the founding members of the Board. Now, as I see the PCAOB emerging from its start-up phase to its present capability to carry out the responsibilities assigned to it by the Congress, I am even more appreciative of the opportunity